Amazon.com (NASDAQ:AMZN) is a company full of surprises. Due to its lack of transparency it's hard to cover everything about it without spending a lot of time digging. During this process, it's not just the lack of earnings or massive valuation that surprises. This article will cover 3 more things that are not widely known but whose effect is significant when valuing Amazon.com.
One of the overlooks problems Amazon.com faces is its changing mix. While I have already highlighted how the changing mix between media and EGM (electronics and general merchandise) could account for most of the profit implosion since 2010, there's also another detail that's important.
That would be the usage of USPS's "Media Mail". Using "Media Mail"makes it possible to ship products such as books and CDs at much more favorable rates, and when Amazon.com was mostly a bookstore/media store, it made large usage of this. However, as Amazon.com shifts towards EGM, this cheaper mode of distribution is gone. (A comparison of costs can be found here)
This also probably helps understand why general mail-order retailers such as the Sears Catalog ended up losing against traditional bricks&mortar stores. Put simply, in high volume items the mail-order catalogs could not compete due to the cost of shipping.
The Sears Catalog also puts to sleep another thesis that crops up now and then regarding Amazon.com: The thesis that it's practicing low prices now to build up a monopoly, and will raise them in the future when it dominates. Why is this put to sleep because of the Sears Catalog? Well, because for part of its history the Sears Catalog was alone as the long surviving generalist mail-order catalog. Did such event allow it to practice monopoly pricing? It didn't, because the Sears Catalog was just another channel - just like Amazon.com.
Amazon.com capitalizes a good amount of internal developed software. This is allowed by GAAP but it actually transforms the expense of having the engineers there programming into depreciation+capex. This in turn inflates EBITDA and operating cash flow, while not affecting free cash flow (because the money goes out through capex) and slightly inflating earnings (because costs take a bit longer to be expensed through depreciation, so while growing expenses are slightly lower in the current period). This is covered in the latest 10-Q here:
During Q2 2013 and Q2 2012, we capitalized $141 million (including $25 million of stock-based compensation) and $111 million (including $19 million of stock-based compensation) of costs associated with internal-use software and website development. For the six months ended June 30, 2013 and 2012, we capitalized $271 million (including $44 million of stock-based compensation) and $199 million (including $32 million of stock-based compensation) of costs associated with internal-use software and website development. Amortization of previously capitalized amounts was $107 million and $77 million for Q2 2013 and Q2 2012, and $209 million and $148 million for the six months ended June 30, 2013 and 2012.
This is now at a run rate slightly in excess of $500 million/year, so TTM EBITDA and operating cash flow look $500 million higher than they would otherwise be, and capex also looks $500 million higher than otherwise. The impact on earnings is minor, at just $34 million (the difference between what's capitalized and what's amortized).
Just how low could Amazon.com go?
It's not easy to visualize how low Amazon.com could trade. So I'm going to make it easier. Let us say that somewhere in the future Amazon.com will trade with multiples that are close to those Apple (NASDAQ:AAPL) trades for, today. What does this imply?
Amazon.com is expected to produce $0.87 per share in earnings for 2013. The 2014 estimate are entirely unreliable as they do little but get chopped down (as a guide, 3 years back Amazon.com was expected to earn north of $5 per share during 2012, and it ended up actually having a net loss for that year). But let's go with the $0.87 per share.
Apple trades at 12.2 times 2013 earnings estimates. I am not even going to deduct Apple's huge cash load, which would lower this even more. 12.2 times Amazon's 2013 estimates comes to $10.61 per share. So if Amazon.com traded at the same earnings multiple as Apple, it would trade at $10.61 instead of $318.
A more favorable comparison for Amazon.com would be using an EV/EBITDA multiple. Apple trades at around 5.2 times EV/EBITDA (this excludes cash from its market capitalization).
As for Amazon.com, it had EBITDA of around $3.0 billion in the last 12 months. This EBITDA is CSOI+amortization and depreciation-share based compensation-amortized software costs. Lots of people "maximize" Amazon.com's EBITDA by including share based compensation (which has nothing to do with "Earnings Before Interest, Taxes, Depreciation and Amortization) as well as amortized software costs (which then get taken away in capex).
Roughly speaking, then, for Amazon.com to trade at 5.2 times EV/EBITDA, its EV would have to be 5.2 times $3.0 billion. That's $15.6 billion, $18.6 billion for market cap if we consider net cash. Over 465 million shares, that's $40.0.
In short, for Amazon.com to trade at the same earnings multiples as Apple, if you have to drop 87%-96%. And obviously, it's not impossible for Amazon.com to trade at the same multiples as Apple, and this has once happened to eBay (NASDAQ:EBAY).
Amazon.com is a box full of surprises, many of which distort the already high valuation it carries. This article covered "Media Mail" as well as capitalized software costs, and showed just how much Amazon.com could drop if it simply fell to a valuation in line with what Apple trades for.
This means that Amazon.com could have 87%-96% downside, much like it experienced during the bursting of the 2000 dotcom bubble. And such a downside wouldn't even make it trade at irrationally low valuations - it would simply make it match what Apple trades for today.
P.S. Content costs are also flowing through Amazon.com's amortization schedule and being added back to EBITDA and operating cash flow, but it's still hard to quantify how much of an effect this has.