In 1997 he spun a tale. It's all about the long term, he said. The markets bought it and kept buying it for the next 15 years. The stock kept rallying all these years and is up 250% since the bull market peak. The top line of the company has been parabolic, but the bottom line has been almost flat. Yes, I am talking about Jeff Bezos and Amazon (AMZN).
Amazon stock returned 38% last year and investors should not be complaining. Of course they are not, because the going is good and the stock hit its all time high yesterday. Questions will arise when the boat hits rough waters. But I want to raise a few questions now, not about the stock, but about the business in general.
Amazon is a unique business in a lot of respects. The revenues have grown every single year at a 20%-30% clip but its net profit margin has always been in the low single digits between 0% and 3% except in 2004 when it managed 8%.
Amazon is an eclectic combination of a variety of businesses. It's a virtual shopping mall and so it competes with the likes of Wal-Mart (WMT), Target (TGT), and Costco (COST). It generates a significant amount of revenue through electronic sales, so much so that Best Buy (BBY) complains people check out the look and feel of the product in their stores but buy it on Amazon. It manufactures and sells the Kindle and there it faces competition from Apple (AAPL), Google (GOOG) and Samsung (GM:SSNLF). As a manufacturer of e-book readers, it faces competition from Barnes & Noble (BKS), Sony (SNE) and a host of other companies. One of the most important aspects of Amazon's business is tracking customer behavior and targeting him with the right kind of products. Its nearest competitor in this respect is Google, Yahoo (YHOO), IBM (IBM) and Microsoft (MSFT) who compete for the amazing computer scientists and top class programmers who don't come cheap. With the launch of Amazon web services, Amazon directly takes on names like Rackspace (RAX), Salesforce.com (CRM), VMWare (VMW) and others. Looking at the competitors in each of these segments, I am sure it is not easy being Amazon or Jeff Bezos.
In the truest sense of the word, Amazon is an online conglomerate. It is a diversified entity, a Jack of all but a Master of none. Let us try and focus on some of the segments in which Amazon is less than ordinary.
Gross Profit Margin
Amazon defines cost of sales as the purchase price of consumer products and digital content where [it] is the seller of record, inbound and outbound shipping charges, and packaging supplies (source: 10-K). Amazon's gross profit margin has been 22% for the past six years. In contrast, a company like Wal-Mart derives its niche by sourcing products from the cheapest vendors across geographies and has gross margins around 25%. Target has positioned itself to service customers at a higher end and boasts of gross margins of near 30%. Even Best Buy which is smaller in comparison (and has smaller economy of scale) has a gross profit margin of 25%. Amazon's gross profit margins are lower than its competitors and that tells us that its strategy and business model lend it no significant edge.
Fulfillment costs are the costs associated with operating and staffing [Amazon's] fulfillment and customer service centers, including costs attributable to buying, receiving, inspecting, and warehousing inventories; picking, packaging, and preparing customer orders for shipment (source: 10-K). These costs were 9.5%, 8.5% and 8.3% of revenues in 2011, 2010, and 2009 respectively. Other brick and mortar retailers do not have costs associated with shipping goods to the customers as they are responsible for carrying home their own purchases. So Amazon's business model adds this extra cost that it has to bear.
Stock-Based Compensation for Operating Expenses
Amazon has categorized $557 million as stock based compensation for 2011. It further categorizes these expenses as follows:
Stock based compensation
Technology and content
Among all of the above, I can totally understand Amazon paying with stock for technology and content, but what about general and administrative, fulfillment and marketing expenses? It is rare to see a company paying for such expenses using stock. A simple question that arises is, does Amazon provide stock based compensation only to its employees or to its vendors and service providers? At least from the information in the 10-K, I am unable to reach a fair conclusion.
Here is what Amazon states in its 10-K:
Our financial focus is on long-term, sustainable growth in free cash flow per share.
Amazon has indeed had positive free cash flows, but hasn't that been achieved by paying with stock for expenses that a company would normally pay with cash? And if the answer is yes, isn't Amazon directly overstating its operating cash flow by $557 million?
The Kindle Universe
When Amazon launched the Kindle, investors thought that finally the long term investments were beginning to fructify. Alas, this was far from true. After selling hundreds of thousands of devices investors see that nothing has been added to Amazon's bottom line. It seems that Amazon is keen on building the entire Kindle universe, but hasn't that already been achieved to a significant extent. E-book sales now surpass sales of printed books and thousands of self made authors have published e-books exclusively for Kindle. All this should have added to the bottom line in terms of net income, but it has not, which suggests that this segment too is operating only at cost.
Amazon Web Services
A great deal is being said and written about AWS, but it is still less than 3.3% of Amazon's revenues. (Here is how I arrived at the 3.3% figure: Amazon categorizes revenues from AWS as not belonging to media or electronics but in the 'other' segment and that is 3.3% of its total revenues). Given Amazon's past history of foraying into a new business segment, it is likely that AWS too is just breaking even or might be losing money. If investors are buying into the stock thinking that AWS is going to be a game changer for Amazon then you will surely be disappointed.
Beating Around the Bush and Non-Disclosures
Amazon chooses not to disclose some very important details about its business like the sales figures for Kindle or the number of e-books sold. It derives some kind of pleasure by not communicating with shareholders by talking in numbers. Instead it chooses to build an aura around itself by talking in vague terms like this: Amazon customers purchased enough copies of the "Fifty Shades" trilogy by E.L. James to create a stack 445 times taller than the Space Needle.
Only a few analysts like Paulo Santos from Seeking Alpha would put in the effort to estimate the actual number as in this article. So much is left to subjective interpretation that investors may want to include a non-transparency risk premium in their valuation models.
Let's now turn to extraordinary valuations and the less I write here the better because I am not sure what kind of a valuation model would suit a stock like Amazon. Ratios on the extreme side of the spectrum and unpredictable cash flows render relative valuation and DCF useless. Or should any valuation model be used at all, except for the idea that encourages investors to party till the music is on bearing in mind that the roof above may collapse any time.
I think the moral of the story is clear: An investor not comfortable with too much risk in his portfolio should not invest in a stock like Amazon. For people who like to do stuff the Vegas way, it's all yours.