Amazon Is No Bargain

Aug.26.13 | About: Amazon.com, Inc. (AMZN)

In the past month, Apple (NASDAQ:AAPL) was as profitable as Amazon (NASDAQ:AMZN) has been in its 20-year existence. Despite this stunning fact, Amazon has a $132 billion market capitalization, 29% of Apple's. Does this valuation make any sense? AMZN bulls have been strongly answering in the affirmative, explaining that Amazon's booming sales will translate into massive profits as the company gradually raises prices.

This theory cannot be dismissed out of hand as stock prices are reflective of the present value of anticipated future cash flows, not previous ones. As such, AMZN could theoretically be worth $132 billion despite its historic low/non-existent profitability. In this article, we will tackle head-on what Amazon will have to do to merit its current valuation while trying to find what its true value is.

Coming into this exercise, I was skeptical about Amazon's ability to ramp up profits because we've been hearing this argument for years. Back in 2008, we were told increased profitability was just around the corner; it wasn't. Increased investment in distribution centers has been blamed for the stagnation around the flat-line, and I think it is clear Jeff Bezos hasn't seen profitability as a key goal so far. I hope the bulls are right that Amazon can grow profits, but for five years, this thesis hasn't come true, which makes me skeptical about its ability to deliver in the future.

Admittedly even though the bulls' fundamental thesis hasn't played out, they have clearly prospered in the stock market with AMZN sitting near all-time highs, up 240% in the past five years. The question we have to determine is whether or not this is an example of market irrationality or rational expectations for 10-year growth. I hope my models can better color your opinion.

Under my three models, a bull, base and a bear case, there are several macroeconomic assumptions I want to explain. First, I believe a major reason why Amazon has grown sales so dramatically in the past 10 years is not only managerial excellence but the broader secular trend toward shopping online. Over the next 10 years, I anticipate continued migration toward Internet shopping. However at some point in the future (I'm not smart enough to know exactly when), online retail share will mature. In other words, at some point, Internet and physical sales will reach their long-run mix. I believe physical stores will always exist, so online shopping's market share will always be below 100% - 50% is not a bad long-run estimate.

As we hit that point, Amazon's sales growth will be closer to nominal GDP growth, with deviations related toward market share gains and losses. Over the past 10 years, Amazon has outpaced GDP because its customer base was expanding, as online sales mature and that base becomes everyone, its long-run growth rate moves closer to nominal GDP. From this view, I see Amazon's sales growth decelerating over the next decade.

Next, under all three cases, I assume that Amazon can ramp up profitability to some degree, the question is how high. For this, I think it is important to classify Amazon as some type of retailer, and for me the best classification is a diversified discount retailer, making the most appropriate comparison companies like Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and Costco (NASDAQ:COST). Here are their profit margins: WMT 3.78%, TGT 4.09%, and COST 1.78%. Without stores, Amazon argues it has a leaner cost structure that should allow for somewhat higher margins. However if Amazon were to get too greedy, another Internet retailer could come in and undercut it on price. Given this push and pull, I think it is fair to cap AMZN margins above but not substantially higher than competitor retailers, no more than 5%.

Last, the question as investors we need to examine is what is an appropriate long-run multiple that Amazon should trade at. The number is clearly below its current multiple over 100x, but how should it trade relative to the market? In my base case, I assume it will trade at the market's multiple of 15x. In the bull case I give it a premium for being a technology company (which typically get a P/E boost) of 20x, while in my bear case I give it a 10x multiple to put it more in line with historic valuations for big-box retailers with decelerating growth. With these things said, here is what I find to be Amazon's value under three scenarios.

Bull Case

Click to enlarge

In my bull case, I have modestly decelerating sale growth, reflecting that Internet sales have an extremely high ceiling. Under this scenario, Amazon hits $444 billion in sales, making it as large as Wal-Mart, which to me, feels a little overly optimistic. At the same time, I give Amazon credit for a leaner business model, by ramping margins 100bp above Wal-Mart and other discount retailers. At the same time, I gradually lower P/E to 20x, reflecting its still high growth and inclusion in the technology sector. Doing all of these things, there is an annualized 10-year return of 12.39%; not too shabby, but certainly not gangbusters. Under my optimistic bull case, Amazon would likely outperform the S&P 500 by a considerable margin but would not produce eye-popping returns.

Base Case

Click to enlarge

My base case, or the scenario I see most likely, has moderately decelerating sales growth, reflecting Amazon's growing size and a reasonable ceiling for Internet sales. Amazon would still reach $360 billion in revenue, likely making it one of the 10 largest companies by revenue in the world. I also assume that AMZN can gradually grow profits by cutting back on investment and raising prices. I place it in the middle of the pack among discount retailers with a terminal 3% margin. As the company gets larger, its future sales growth will more closely correlate to GDP, so I give it a market multiple of 15x. Under this scenario, AMZN is an underperformer with a lost decade, appreciating a meager 2.21% annually. This lackluster return is not rooted in weak performance (the company still grows massively) but in a stock that is currently detached from reality.

Bear Case

Click to enlarge

In my bear case (which I'd note isn't all that pessimistic), sales growth decelerates more rapidly, growing at a more mature 7.5% pace in 2023. Still, Amazon would pass $300 billion in sales. The company's profit margin ramp would be slower than expected, reflecting management's tendency to overspend and the relatively weak pricing power of discount retailers. AMZN's margin would max out at 2% while its P/E reflects its status as a discount retailer whose fate is tied to economic growth. Now, Amazon's share would fall noticeably over the next 10 years, at an annualized 7.5% clip. Again, this shows how overheated AMZN stock is because the company quadruples sales in a decade, yet sees its value cut in half.

Conclusion

Looking at my three models, AMZN is an unattractive risk/reward stock at current levels because its current share price is reflective of expectations for extraordinary performance so that the slightest hiccup could send the stock tanking. To earn 12% annually, AMZN would have to become larger than Wal-Mart with superior margins; under a more reasonable case, AMZN is flat, and under a bear (but not overly pessimistic) scenario, the stock falls by more than 50%. None of these scenarios account for the possibility that another online retailer could emerge to take share back from AMZN. In that situation, revenue growth would likely be worse than under my bear scenario, resulting in steeper losses. Amazon is a great growth company, but the stock is simply too expensive here. Buying a company with a 300x multiple for a 2% annual return is an unfavorable risk/return profile. At current prices, AMZN is irrationally expensive and should be avoided. Based on my three models, a fair price for AMZN would be in the $120-$150 range, which would provide above-market returns in my base case with no losses in my bear case. However, I would be hesitant to short it outright, given its historical detachment from reality. In this case, this best play may be to have no position at all; your money is better off elsewhere.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.