Amazon Is Looking Like Starbucks of Yore: Too Expensive

In November of 2004 I wrote a piece entitled “Sleepless in Seattle” which postulated that shares of Starbucks (SBUX) were trading at such a high valuation (forward P/E of 48) that even if the company grew handsomely over the following few years, the stock’s performance was likely to be unimpressive. I projected an aggressive three-year average annual earnings growth rate of 20% and a P/E of 40 by 2007. I warned investors that even if those aggressive assumptions were attained, Starbucks stock would only gain 6% per year over that three year period.

The analysis proved quite accurate. Starbucks continued to grow its profits nicely, but the stock’s valuation came back down to earth. After three years had passed, Starbucks stock was actually trading 12% lower than it was when I wrote the original piece.

Today, shares of online retailer Amazon.com (AMZN) remind me of Starbucks back in 2004. Despite a cratering stock market and weak retail market, Amazon stock has been quite resilient. After a strong fourth quarter earnings report (released yesterday after the close of trading), the stock is up $9 today to $59 per share. Profits at Amazon for 2008 came in at $1.49 per share, which gives the stock a P/E of 38, which is very high, even for a strong franchise like Amazon.

I decided to do the same exercise with Amazon. I wanted to make assumptions that were both reasonable but also fairly aggressive. I decided that an average earnings growth rate of 15% over the next five years fits that mold. Projecting the P/E in January of 2014 is not easy, but given that Amazon’s growth rate should slow as the company gets larger, I think a 20 P/E ratio is reasonable given where other retailers trade (less than 15x). By 2014, Amazon’s growth rate should be more in-line with other retailers similar in size, so I chose 20 to be higher than average, but not in nosebleed territory like the current 38 P/E.

After some simple number crunching, we can determine that Amazon would earn $3 per share in 2013 in this scenario. Twenty times that figure gets us a share price of $60, versus today’s quote of $57. Even if the company hits these assumptions, shareholders will make a total return of 5% (only 1% per year!) over the next five years. I would be willing to bet the S&P 500 index far outpaces that rate over that time.

Obviously these assumptions could prove inaccurate, but I think this exercise is helpful in illustrating how hard it is for stocks that trade at lofty valuations to generate strong returns over the long term.

There is one interesting thing about Amazon’s business that I think is worth pointing out. You may recall that one of the bullish arguments for an online retailer like Amazon was that they could have a lower cost structure by eliminating the expenses associated with renting and operating large brick and mortar storefronts. Having a 100% online presence was supposed to result in higher profit margins, and therefore investors could justify paying more for Amazon’s stock.

It seems that argument has not been realized. Amazon’s operating margins in 2008 were 4.3%. If we look at brick and mortar retailers that are similar in business line and/or size, we find that Amazon’s margins are actually lower than their offline competitors. Here is a sample list: Kohls (KSS) 9.9%, JC Penney (JCP) 7.6%, Macy’s (M) 7.2%, Target (TGT) 7.8%, and Best Buy (BBY) 4.6%.

Maybe online retailers have to spend more on research and development and call center staff than offline stores do, thereby cutting into the margin advantage. Amazon also offers free shipping on orders of $25 or more, which many say they could eliminate to boost profits. Maybe so, but sales would be affected to some degree if they did that, not to mention customer loyalty.

Nonetheless, to me these statistics help make the case that a 38 P/E for Amazon is way too high. As a result, returns to Amazon shareholders over the next several years could very well be unimpressive, just as was the case with Starbucks five years ago.

Disclosure: Peridot Capital was long Best Buy and Target at the time of writing, but positions may change at any time

Comments

[Network Effect:]

Amen brother, but Amazon is yet another example of why wall street is a con man's game. The pros are long so they don't talk about this, they choose to talk about the positive side of the story. Once they've made their money and are out, they will then talk about all these negatives. The key to making money in the stock market has nothing to do with fundamental analysis. It has to do with figuring out how big money is trading, and nothing else. they will focus on whatever they decide they want to focus on, and for the past couple years, it appears that they are more and more focusing on whatever main street is not focusing on. It takes two to trade, and the story is clear as day the last couple years - wall street trades the opposite of whatever main street trades, regardless of the story. They just focus through the media on the part of the story that backs their trade. Hence the con.

Jan 30 08:05 PM

[Lightway:]

When taken in the context of online and offline retailers, those valuations might not make sense. However, Amazon has morphed into something more than just an online marketplace. It now makes tons of cash off of reselling its technology infrastructure, via hosted solutions.

All the latest buzz regarding "the cloud" will typically bring up Amazon's hosting services. There are tons of startups and other businesses out there now using Amazon's IT infrastructure. They've been in the game and know how to scale for years now, so they have the know-how and the business model already set in place to leverage the currently popular (and arguably overhyped) "cloud" model.

They are starting to overlap with similar services being introduced by Microsoft and other big providers in that space. Amazon has become more of a platform than a merchant.

Jan 30 09:31 PM

[johngonole:]

Agreed. Amazon sells for much much higher PE. The market Cap is almost twice that of Ebays. Yet EBAY has almost twice the amount of earnings in absolute terms. Makes no sense. I've wondered for a long time why AMZN gets such a premium. I will admit that their performance last quarter was fantastic especially in this environment. Still price has no where to go from here but down. What would be the catalyst for it to go higher. If earning go up 10% it may yet go up another 10%. If earnings drop 20% it could drop 60-70%. Risk to reward sucks. After all its just a retailer.

Jan 31 01:44 AM

[JudeJin:]

there's rumor that certain major shareholders(owner/man... of some chinese companies(listed on nasdaq) pay clients kickbacks(bribes) using proceeds they got from selling shares in the open market.

is it possible amazon's boss is funding certain stock manipulators backing amzn using the proceeds he got from selling his amzn holdings?

anything is possible in this con world!

adidas' slogan: impossible is nothing. sounds funny at first sight, but actually makes perfect sense!

IMPOSSIBLE Is Nothing!!

Jan 31 04:12 AM

[ursmax:]

I think you're comparing AMZN to the wrong companies.

Better to apples to apples and rate them against direct competitors like Barnes&Noble (BKS), Books-A-Million (BAMM), etc. Border (BGP) seems to have had problems lately, and might need to be excluded for the time being.

Interestingly enough operating margins for AMZN, BKS and BGP are virtually identical according to finance.yahoo. Net income as a percentage of revenue is some 3.1%(AMZN), 2% for both BKS and BAMM. PE, however, are 40, 8.6 and 3.2.

And don't forget the dividend, which AMZN does not pay (yet?).

The conclusion, for me, is the same:
risk/return for AMZN not good enough to justify an investment. one even might consider going long BKS/BAM and short AMZN.

Jan 31 08:01 AM

[morph366:]

Re Ursmax's suggestions about a pairs trade with a bearish bet on AMZN.

Intuitively long BKS and short AMZN sounds like a good idea but there is no inherent reason in these types of correlation pairing, especially in the short term, why the path followed by the different sides of the spread could not be less risky than just being long AMZN (or short AMZN for that matter).

Jan 31 09:05 AM

[Harry Tuttle:]

Why it trades at a premium:

1) Large short interest (about 10% of float)
2) Long term holders
2.a) Bezos 20% is never traded
2.b) The mutual fund companies like TRowe and Legg Mason tend to stay long and wrong until they face redemptions.

Fundamentally, of course, Amazon is a great albeit expensive retailer.

Jan 31 09:53 AM

[William Orfly:]

I agree with general direction of the article: an objective analysis of Amazon points to an overpriced share price relative to longterm earnings growth. That conclusion, however, does not exclude the possibility that Amazon will trade much higher than the projected $60 fair value price. Fads, though they always fade, evade short-term rational evaluation. Unfortunately, this analysis doesn't address short-term factors in play in todays market that may push Amazon higher. For example, Amazon may grow faster on an earnings basis in the next two years than it did in the last two years, as a result of decreased competition, or the share price may jump as investors may rush to Amazon as a relative value play.

Furthermore, while the 2004 analysis of SBUX appears to have been correct, after 5 years, it was at least a year too early and would have missed a possible additional 40% in investment gains (SBUX peaked in mid 2006). Assuming this analysis is equally premature, and that Amazon's market of millions of products is much more durable than Starbuck's single beverage based product line, an investor should be able to book an additional 20% in gains in the next year (and based on the historical performance of the S&P, I'm not sure anyone is honestly currently relying on investment projections extending much longer than one year).

Jan 31 04:33 PM

[Mark Krieger:]

nice article----the fact that AMZn gave guidance that actually could generate a 37% decline in earnings in the first Q ( or a gain as high as 6%) makes your earnings growth asumption of 15% per year and $ 3.00 per share by 2013 sound llike wishful thinking. The stock is no bargain anymore---

Jan 31 08:51 PM

[Jason22222:]

You guys need to pay more attention to cash flow. AMZN has a negative working capital cycle which isn't well-reflected in GAAP EPS. FCF yield is a remarkable ~6%, the P/E equivalent of <20x, and their net cash position is 15% of the market cap. GAAP EPS isn't perfect and, as a result, nor are P/Es.

Feb 01 11:00 PM

[DeltaHotel:]

NetworkEffect you are absolutely spot on my friend! I used to work at a big investment bank but before that I managed my famiy's stock portfolio and did quite well being long Commodities and Mining stocks from 2004-2008.

However what I am trying to say is that I agree with your point about "big money trading" having worked at a large IB - Fundamentals and technicals quite frankly irrelevant with regards to the stock market nowadays.

The ONLY thing that moves stocks is fast money i.e Hedge Funds, and Institutional Investors like mutual&pension funds.

My sole piece of advice to any investor would be : Find out what Hedge Funds & other "big money" players are buying or shorting and follow suit.




On Jan 30 08:05 PM Network Effect wrote:

> Amen brother, but Amazon is yet another example of why wall street
> is a con man's game. The pros are long so they don't talk about this,
> they choose to talk about the positive side of the story. Once they've
> made their money and are out, they will then talk about all these
> negatives. The key to making money in the stock market has nothing
> to do with fundamental analysis. It has to do with figuring out how
> big money is trading, and nothing else. they will focus on whatever
> they decide they want to focus on, and for the past couple years,
> it appears that they are more and more focusing on whatever main
> street is not focusing on. It takes two to trade, and the story is
> clear as day the last couple years - wall street trades the opposite
> of whatever main street trades, regardless of the story. They just
> focus through the media on the part of the story that backs their
> trade. Hence the con.

Feb 28 06:21 PM