Whatever your opinion of Amazon (AMZN) the stock (I hate it), you have to respect Amazon the company. Over the last 15 years, Amazon has been consistently taking share from legacy brick and mortar retailers thanks to its leaner cost structure (no stores). By offering lower prices and good customer service (free returns), the company has turned into a $60 billion revenue behemoth from an online bookstore located in Jeff Bezos' garage.
Now Amazon's growth hasn't been victimless, far from it. In essence, it has been taking share from brick and mortar stores, cannibalizing their sales. To expedite this process, Amazon sells many of its goods at cost. The firm has basically taken $60 billion in profitless revenue from stores who used to profit from those sales. The bull case on AMZN is that it will eventually raise prices marginally, which will massively grow profits. Whether this happens remains to be seen.
While I think there is great uncertainty around Amazon's ability to increase profits, I think it is a foregone conclusion that it will keep growing sales by pursuing its low price strategy. In the past few years, Amazon has killed Borders, Circuit City, and Linens N Things while also seriously wounding Barnes & Noble (BKS), Best Buy (BBY), and now Staples (SPLS).
Tuesday morning, Staples reported a horrendous quarter with profits down over 10% and guidance for a revenue decline over the rest of the year (their 10-Q can be found here). In fact, the company hasn't grown sales since 2010 even as the economy has slowly ticked higher and as it has gained share in office supplies. Staples is another company who has seen some marginal demand move to the internet. Many retailers operate with profit margins well below 10% (often closer to 5%), so even a small drop in sales can have an outsized impact on sales. Staples has a good management team, so like Best Buy, it may be able to avoid total collapse at the hands of Amazon, but it will never be the company it was before Amazon when the stock was trading 65% higher.
How can we best profit from Amazon's continued market share growth? I suppose the most obvious strategy would be to purchase AMZN. However, I don't think this is the best strategy. With AMZN trading at 300x earnings, the stock is extraordinarily expensive. Here's the model I ran. Assuming you want an annualized share price return of 8% in AMZN over a decade (probably on the low side of what investors want in a high growth), the stock would trade at $645. Ten years from now, AMZN should be a more mature company, trading at a normalized P/E (I used 15 times). That would translate to $43 dollars in earnings, or an annualized growth rate of 45% over 10 years. If you want a higher return, you would need even faster profit growth! Assuming it grows profits at a more likely 20%, it has $6 in earnings power in 2024, suggesting a share price of $100.
Therefore to me, AMZN seems like a high-risk, low reward trade. The theme I am presenting is that Amazon continues to grow revenues not profits. As such, the best way to play the internet revolution is to find those retailers who are most likely to cede those sales and short them (probably through a put strategy). To do this, I tried to find common themes in the six companies listed above who have most suffered. From there, I looked for other companies who also fit these traits. Here is what I have found.
First, these companies are selling a product more than they are selling an experience. Consumers go into a Staples or Best Buy with specific products in mind, i.e. they need certain supplies or a television, compared to other retailers who are also selling a lifestyle and make shopping an experience, see Costco (COST) and Home Depot (HD). Making the shopping experience unique essentially adds value to their product and increases barrier to entries; stores who only sell products will be forced to compete solely on price, which is a battle physical stores cannot win against an internet giant. Next, these retailers don't sell exclusive products. If you want a Panasonic TV, or Dell laptop (DELL), you could shop in 20 different places, not just Best Buy. Compare that to a Tiffany's (TIF) where you have to go to their stores to buy their products. Exclusive distribution provides another barrier to entry while a non-exclusive platform leaves you competing on price yet again. All of these companies also have low margins, which make their existence highly dependent on the slightest change in sales. In essence, these firms add little value and act as distributors for the product manufacturers who take the highest profit cut from each sale. It isn't surprising that these physical distributors have been crushed by an online one.
When screening for these criteria, I found one retailer that is especially vulnerable to Amazon: Bed Bath and Beyond (BBBY). Right off the bat, we should be concerned about BBBY because Amazon destroyed its chief competitor, Linens N Things in 2008. The absence of a chief competitor has helped BBBY in the past few years compete with Amazon. Interestingly, BBBY's story parallels Best Buy; the implosion of Circuit City help Best Buy for a couple of years, but we now know it was not sustainable as Best Buy has struggled for 3 years.
This would suggest that Bed Bath and Beyond should start to see pressure from Amazon in the coming quarters. The company sells virtually no proprietary products. In other words, you could buy the goods they sell online or at other stores; when you find a blender you like, you'll buy the cheapest one around, probably on Amazon. BBBY is poised to be Amazon's next victim.
Currently, the stock price does not reflect deteriorating financial performance with its shares trading at a rich 16 P/E. Analysts do remain bullish on the stock and point to the firm's 3.4% same store sale increase in their first quarter (ending June 1, 2013). However, despite this sales increase, profitability fell by 2%! To me, this is indicative of a price war. Looking at other fallen firms, their revenue held in far longer than their profitability. For three years, BBBY has maintained margins around 10%, but they have since fallen closer to 7%. As Amazon continues its expansion into home goods, I expect further margin erosion, which will make it virtually impossible for BBBY to meet next year's expectation of 10% EPS growth.
Trading at 16x earnings with a PEG of 1.5, Bed Bath and Beyond is priced for perfection and does not reflect the substantial threat Amazon poses. It fits the profile of past casualties as it competes primarily over cost with non-exclusive goods, a war a physical store cannot win. With deteriorating margins, we are seeing the beginnings of this price war. BBBY will not go away tomorrow; its price just fails to reflect the challenges it faces. Similar to Staples, I foresee a slow bleeding at BBBY with stagnating and eventually declining profits. It should trade more like 12 times, or $60. I would initiate a short here; for those who prefer dealing in options, the Feb 22 $70 put makes sense. The move to online shopping is an undeniable secular trend that will significantly damage BBBY's prospects. To bet on continued revenue growth in Amazon, shorting vulnerable retailers is the best strategy as AMZN is extraordinarily overpriced while many retailers are not pricing in the existential threat to their business model.