“In theory there is no difference between theory and practice. In practice there is.” Today those famous words from Yankee legend Yogi Berra ring disturbingly true. You see, one of the theories I’ve pounded into readers’ heads over the years is that share prices ultimately follow earnings.
As earnings increase quarter after quarter, so should share prices. And as they decline quarter after quarter, so should share prices. Now, I’ve seen this theory play out in practice so many times – heck, I’ve shared definitive proof that the S&P 500 Index as a whole abides by this theory – that I often arrogantly challenge people to try to find an exception.
I had it down to an exact science. Well, so I thought! Somebody finally found one – online retailing juggernaut, Amazon (NASDAQ:AMZN). Here’s why I have to learn to keep my big mouth shut and, more importantly, why I wouldn’t invest in Amazon’s high-flying stock.
A Difference At the Top and Bottom
No doubt, Amazon has been “the most disruptive force” in the online retail market, as Morningstar analyst, R.J. Hottovy, said. Amazon’s low-cost operations helped it amass an active customer base of 209 million users as of March 2013. That’s equal to about 3% of the world’s population. This customer base keeps growing, too. It’s up by more than 20% per year over the last five years. And they’re buying more, too. Sales increased by an amazing 32.4% per year over the same period.
As it stands today, Amazon’s $61.1 billion in sales in 2012 make it the world’s highest grossing retailer. Not bad for a lowly dot-com company that was founded less than two decades ago. If that wasn’t impressive enough, nobody else even comes close to matching up with Amazon. In fact, it would take Amazon’s nine closest competitors joining forces to put up the same amount of sales. But with all that being said, there is one colossal problem – none of Amazon’s growth is dropping to its bottom line.
Whereas sales increased an impressive 31.4% on average over the last eight years, net income only increased by an average of 2%. I know what you’re thinking. That can’t possibly be true. After all, if share prices ultimately follow earnings – and Amazon’s stock is up over 600% during that time period – earnings must be increasing. But they’re not. Hence the lofty forward price-to-earnings ratio of 80.
So what’s going on? Well, Amazon Founder, Jeff Bezos, religiously reinvests sales in new growth initiatives. Think Kindle, cloud computing, the acquisition of Zappos.com, etc. So, in reality, hope is the only thing driving Amazon’s share prices right now. As in, investors hope that one day Bezos will slow down the pace of reinvestment so more sales dollars drop to the bottom line. I wouldn’t bank on that, though.
Amazon faces increasing competition from the likes of eBay (NASDAQ:EBAY), Google (NASDAQ:GOOG), Yahoo (NASDAQ:YHOO), Apple (NASDAQ:AAPL) and Wal-Mart (NYSE:WMT), as well as a plethora of other, more specialized companies in the online payment, comparison shopping and video streaming spaces.
Heck, Google recently launched a handful of competitive initiatives, including Google Shopping for Suppliers, which directly competes with AmazonSupply. As Alfred Lin of Sequoia Capital recently told The Wall Street Journal, “Those two companies are going to duke it out for a long time in just about everything.” I concur!
In the end, with other cash-rich behemoths intent on invading Amazon’s turf, Bezos won’t be able to ease off the reinvestment… not if he wants to maintain the company’s world dominance.
So the company will never be able to grow profits enough to justify its valuation – especially when regulatory battles over sales taxes promise to dampen the expansion of the company’s razor-thin net margin (which averaged just 3% over the last decade).
Bottom line: I expect Amazon’s stock to ultimately match up with my theory about earnings, which could set up shares for a nasty correction. Of course, I could be wrong. Hope could carry share prices even higher still. If I were you, though, I wouldn’t be too eager to put my hard-earned capital on the line on that premise. Just saying.