In an earlier article, I disclosed my short position in Amazon.com (AMZN), arguing that the company isn't built to deliver earnings to shareholders; instead, all its benefits accrue to customers and employees.
Now I'd like to consider one of the main arguments supporting the stock's currently rich valuation. That argument, as I understand it, is that while on its face AMZN might seem a low margin retailer, in reality it's a disruptive, high-growth tech company - and should be valued accordingly.
If we take that claim at face value, there are two relevant possibilities: either the company continues to succeed and uses its disruptive characteristics to enrich shareholders, or the company is overcome by other factors, perhaps a new competitor, consumer vagaries, execution errors, law of big numbers, or what have you.
Historically, the latter outcome has been the norm for the vast majority of companies widely heralded as "disruptive." For recent examples, consider how PALM's Web OS was deemed ground-breaking by its many advocates, yet in the end, even after being purchased by HP, it's come to essentially nothing. Similar examples of exuberant stock valuations can be multiplied at will, from HAND, to CSCO and Sun Microsystems in the 2000's, all the way back to some of the "nifty fifty" stocks like Eastman Kodak (now bankrupt trading as EKDKQ).
Or consider one of Jim Cramer's vaunted "four new horsemen of tech," Research-in-Motion (now BBRY). The company's technology was disruptive, it had first mover advantages and it had one of the most enviable client bases of all time, being installed through virtually all of corporate America. And yet:
(source yahoo finance)
Other even more successful - and more genuinely disruptive - companies to cite would be ones like Netscape and AOL. For those of us old enough to remember it, Netscape was the first company to give us access to the world wide web. In terms of disruption, it doesn't get much better than that. Yet after peaking at $174 per share in December of 1995, the company was trading below $30 a share a year later. AOL too had a disruptive advantage, one which in some ways mirrors AMZN's. It had a "captive" network of users, which supposedly were going to be easy to monetize. Indeed the market loved the story so much that it bid AOL up to a size where it was able to purchase Time Warner in an all stock deal. "What you'll see early on and very quickly are a lot of things AOL can do together with new forms of functionality that we have not seen in the broadband cable industry," Gerald Levin, Time Warner's chairman and chief executive, told a news conference [at the time]. We all know how that turned out.
So the real risk is that, despite a strong consensus currently extolling AMZN's disruptive invulnerability, the company will suffer the same fate as its many illustrious predecessors.
But for argument's sake, let's assume that AMZN doesn't fall into this category. Instead, let's take the huge leap of faith and pretend that it will retain its disruptiveness indefinitely.
Given that we're here at Seeking Alpha, the question then becomes, how does disruptiveness aid shareholders? That is, when and to what extent can a shareholder expect to benefit monetarily (not just psychically) from his investment in a company that's so far ahead of the curve?
One way to answer this is to consider other historical examples of successful technology groundbreakers. There are only a few to choose from since, as we've discussed, almost every darling company ultimately fails to live up to its hype. Of those few, I've chosen Microsoft (MSFT) as a good comparison. Like AMZN, its disruptiveness was present from day 1; for much of its life shorts derided it as being over-valued; and it's proven to be successful in the long term. My contention in making this comparison is that if AMZN looks relatively over-valued even in the face of one of the best companies in history, then it is likely WAY overvalued absolutely since the risks are that it never even lives up to the optimistic hopes of its advocates.
Now, because Microsoft is older than Amazon, we can't directly compare the key historical operating and valuation performances by calendar date. Instead I've chosen to normalize the data by years after their respective IPOs, as it seems the best common timeline, but one could also look at them by counting the years elapsed after achieving a billion dollars in revenue or some such equivalency. Whichever is chosen will reveal essentially the same trends. Moreover, to give the most conservative case, i.e. the one most favorable to AMZN, I've chosen not to adjust the numbers for inflation. For anyone who wants to do so, here's a handy CPI calculator, and for reference, the adjustment for the first year would be such that MSFT's 1987 revenues should be multiplied by 1.41 to get an equivalent 1997 number. (I'm concerned here mainly with the big picture which is so clear that I don't think there's a necessity to adjust the numbers).
Let's begin by verifying that the companies are comparable. Figure 2 presents the nominal revenues for each company for each year after its IPO (log scale). The figure confirms that we're comparing growth companies of similar magnitude and growth rates.
Now, let's turn to some other measures which can help us understand how these revenues might flow to the owners of the company. (The following four figures will also add context to the data presented in my earlier piece on AMZN).
Figure 3 compares the net margins of MSFT to those of AMZN for each reporting year following their respective IPOs. While AMZN struggles to achieve positive net margins at all (averaging less than $0.01 over its life and often dipping substantially negative), MSFT maintained $0.20+ margins throughout its history. To me at least, MSFT shows us what it means to have a 'disruptive' advantage; it leads to the types of margins that justify high-tech premium valuations. Nothing in figure 3 suggests that AMZN deserves to carry any mantle but that of low margin retailer.
Figure 4 shows the revenue per employee of the two companies as well as the concomitant profit generated by each employee (using end of year employee counts). AMZN employees handily generate more revenue than MSFT employees (often twice as much) yet without exception, MSFT employees bring much more of that revenue to the bottom line. To me this indicates a significant difference in the corporate cultures of each company. And again MSFT would seem to warrant a premium valuation, while AMZN looks much more like a low margin company than a misunderstood ground-breaking tech company.
It's probably also worth noting that because of its profit-driven culture, MSFT managed to generally increase both revenue and profits per employee, while as of late, AMZN is doing the reverse.
But what about market valuations? After all, at the right price any profitable company is valuable. So let's now look at how the market valued the earnings and earnings growth of the two companies. Figures 5 and 6 show the 1 year, 5 year and 10 year cumulative future earnings of each company as a function of the previous year's enterprise value (market capitalization + long-term debt). As will be obvious, two figures are needed because there's an order of magnitude difference in the performance of the two companies, particularly in their early years. So figure 6 is a close-up excerpt from figure 5.
As shown in figure 5, early buyers of MSFT were rewarded with up to $10+ in 10-year earnings for every dollar of their initial investment. Similarly, for each of its first 10 years of post IPO trading, all MSFT investors got at least 100% of their capital back as earnings after 10 years. Moreover, not only has MSFT been historically consistent, but, as the close-up in figure 6 reveals, on every timeframe, MSFT's returns trounce those of AMZN.
In my first article, I suggested that AMZN's valuation needs a wholesale re-examination. I believe that the data in figures 5 and 6 are prima facie evidence of this idea. A real game-changing, disruptive company takes advantage of its technological lead by growing AND delivering the kind of earnings returns exhibited by MSFT; AMZN is in no way in the same category.
So nothing in the comparison suggests that AMZN be awarded the type of premium valuations that a once-in-a-generation company like MSFT merits.
Odds and Ends
Having now put to bed the "AMZN is a misunderstood high-tech company" long argument, it might be worth reflecting on a few related items.
In researching this series of articles, I read/scrolled through all the available 10Ks/annual reports of both MSFT and AMZN. One thing that struck me was that MSFT didn't try to spruce up its earnings reports, indeed in most 10Ks they highlight diluted earnings per share in their summary tables rather than basic EPS, even though the latter would look better. Nor did they highlight their own pro-forma numbers, another sign they were comfortable with the performance of their company vis-à-vis investors.
On the other hand, in his letters, Mr. Bezos goes out of his way to disparage earnings and at one point gives (to me) a weird attack on earnings growth, to instead promote his preferred measure of free cash flow per share (which on its own is a defensible position). See the 2004 cover letter to investors. Similarly, in its earlier days, Amazon often highlighted pro-forma numbers, and analysts (perhaps with the company's encouragement?) still often do the same. As one example, until the FASB promulgated SFAS 123(R) regarding stock compensation, AMZN prominently presented pro-forma numbers which excluded stock compensation. It was as though compensation in stock is not "real money," yet almost every employee receives stock compensation, they're encouraged to cash it out when it vests and it's unlikely most of them would work for their salary alone. This to me supports my basic thesis that Amazon cares almost exclusively about employees and customers - to the detriment and disparagement of owners/investors. (And yes I realize that Mr. Bezos is the biggest owner of the company, but as the company's motto says, his interest isn't in making money per se, it's in making "history." Moreover, at today's prices he's a seller not a buyer -- as his $300M of stock sales in August demonstrate.)
Another point to bring up is that while MSFT had legitimate competitors (the best being AAPL), it seems to me that AMZN's current competitors are more formidable. After taking the low-hanging fruit once controlled by the likes of Borders, Barnes and Noble and the various publishing houses (which Amazon did brilliantly and they should be admired for it), they now face competitors like Apple (AAPL), Google (GOOG), Netflix (NFLX), EBAY, Wal-Mart (WMT) and TGT. They may prevail over all of these, but in my view the competitive risks are higher than the ones MSFT faced, and hence AMZN should be awarded a lower valuation premium than was MSFT, not a much higher one as is currently the case.
Finally, on a personal note, I had never looked at MSFT's numbers closely despite it being the company of its generation. In finally doing so, I found them eye-opening and inspiring, and I hope at least a few other SA investors will experience a similar new-found appreciation. As a trader with more than 15 years experience, shame on me for never having done this previously. The investment game (business) seems to always find new ways to remind me that trading is a never-ending learning opportunity.
Additional disclosure: While I'm short AMZN the stock, I'm also a happy customer of Amazon the company.