We are now around Year 4.5 in one of the greatest bull markets in US history. Since the end of March 2009, the S&P 500 index is up over 100%. Given this environment, it shouldn't be a huge surprise that we're seeing a lot of well-known, rapid-growth momentum stocks flying high. This bunch includes high-profile names such as Netflix (NFLX), LinkedIn (LNKD), Facebook (FB), Tesla (TSLA), and Amazon (AMZN), as well as Zillow (Z) and Trulia (TRLA)
By and large, I view this entire group positively from a business perspective. I expect all of them to continue to grow rapidly over the next five years (with the possible exception of Facebook). Yet, in spite of this, my impression is that most, if not all, of these stocks are significantly overvalued. Of this group, there's only one that I'd be extremely reluctant to short under any circumstances: Amazon.
The joke about Amazon is that it's the world's largest not-for-profit corporation. This is based on the firm's rapidly declining earnings figures and shrinking margins, which have led to paper losses for much of the past two years. Yet, it's also a company that is extremely misunderstood by investors.
Amazon's falling EPS may tell a story of struggle, but don't let it mislead you. The reality is one of a firm that is wildly profitable and growing rapidly. This is a firm with a track record unsurpassed in a low-margin and highly-competitive industry. To put it simply, Amazon is the best company in the United States. Moreover, the threat it poses to the world's largest retailer, Wal-Mart (WMT), may be understated. While the valuation issue prevents me from recommending it as a buy, it is most certainly also a foolhardy short.
The Battleground Stocks
Amazon is one of many "battleground" momentum stocks right now. A few months ago, I wrote about another one of these stocks, when I made the case that Zillow was extremely overpriced at $90. Tesla is also in this group and is, in fact, so overvalued that founder Elon Musk has suggested it's too expensive. There's no shortage of bearish views on LNKD, FB, and NFLX, either. But in my view, Amazon is different.
With about 2% of outstanding shares sold short, Amazon's short-interest is significantly lower than most of the other aforementioned companies. Compare it to Zillow, which has a 39% short interest, or Netflix at 19%, and it would appear that bearish sentiment isn't quite as high for AMZN. However, this may be partly a function of market cap, with AMZN at $146 billion, compared to the other names that are mostly under $30 billion. If you examine it from the perspective of "total value shorted", then AMZN is ranked third in the group at $2.78 billion, behind Netflix ($3.76 billion) and Tesla ($7.41 billion).
On top of significant short interest, Amazon has received a lot of "bearish" media attention. Google "Amazon overvalued" and you'll have no difficulty finding an abundance of commentators.
Paul LaMonica at CNN Money calls Amazon a "great company" that has a "WAY overvalued stock." Here at Seeking Alpha, Paulo Santos, an Amazon short-seller, argues that margins have been deteriorating for years and that it could eventually face issues similar to Montgomery Ward and Sears Catalog. Motley Fool's Travis Hoium views Amazon's stock as being "wildly overvalued" and makes the same low-margin complaint as Santos. Even Barron's jumped in recently, suggesting that Amazon is dangerous to shareholders.
I can't pick too many bones about the idea that Amazon may be overvalued. Rather, I'd contest the idea that Amazon's margins are thin and profits are non-existent. Far from being an unprofitable entity, AMZN has been wildly profitable over the past two years, with rapid growth.
Declining EPS and Operating Margins
What's the case against Amazon? Most accounts suggest that Amazon's earnings have been declining rapidly, and operating margins have shrunk to virtually nothing. The chart below shows diluted earnings per share ["DEPS"] from 2003 - 2012, and you can see that profits peaked around 2010 at $2.53 per share, and have dramatically plunged since then, down to levels not seen since 2002.
(click to enlarge) From this, you can get why the bears view the stock as extremely overvalued at $300. Why would investors bid up the price of a no-profit company, with rapidly shrinking margins? Part of the reason is because these numbers are very deceiving.
Amazon vs. GAAP Accounting
The culprit here is GAAP accounting. Have you ever heard the argument that McDonald's (MCD) is a real estate firm with a restaurant business on the side? Likewise, Amazon is slowly transforming itself to a massive online retailer with a spectacular warehouse REIT side business. As Amazon continues to acquire warehouse space to service customers rapidly, as well as to act as a middle-man with its marketplace merchants, depreciation expenses have grown dramatically. This is one of the primary factors behind Amazon's declining profitability under GAAP accounting.
The chart below shows Amazon's depreciation expenses since 2003.
(click to enlarge) "Fixed Asset Depreciation" is the key figure in the chart above, but I decided to include the overall depreciation and amortization figure, as well. As you can see, fixed asset depreciation has increased from about $9 million in 2004 to $1.15 billion in 2012. In case you're curious, that's an annualized growth rate of 83%!
Notice that fixed asset depreciation is now about 2% of revenues, while it hovered closer to 0.4% - 1.2% in the prior eight years. For 2012, overall depreciation was 3.5% of revenues, compared to historical levels being closer to 1% - 2%. In a low-margin industry such as retail, these are huge numbers! These large depreciation charges come from the expansion of AMZN's physical assets, and they greatly distort GAAP numbers and lead many investors to significantly underestimate AMZN's true profitability.
Let's take a look at some adjusted margins to get a better sense of what's happening. But first, I want to show you gross margins, which haven't actually changed that much over the past decade. In fact, gross margins in 2012 hit their highest levels since 2002.
(click to enlarge)This is telling because it suggests that almost all the changes are on the operating side. The next two figures are adjusted variants of operating income. The first one is operating margin with fixed asset depreciation added back. The second figure looks at Amazon's EBITDA margins.
(click to enlarge) You can see from the two above measures that margins have fallen over the past two years, but not by nearly as much as the operating margin % would suggest. The fixed asset depreciation adjusted margin has fallen from 4.7% to 3.0% (a 34% decline), compared to operating margins which have fallen from 4.1% to 1.1% (a 73% decline). Meanwhile, the EBITDA margins show an even smaller decline, hitting 5.8% in 2010, and falling to 4.0% in 2011, before rebounding back to 4.6% in 2012.
Of these measures, I'd put the most emphasis on the EBITDA margins, which should eliminate most of the distorting factors involved. While this figure has fallen a bit over the past few years, it's not nearly as bad as the bears have argued.
Estimating Real Profitability
In order to account for all the depreciation, I've come up with a few alternative measure of Amazon's profitability. I've alluded to both already. The first takes operating income, adds back fixed asset depreciation, then assumes a 30% tax rate. You can see the results below.
With this metric, I came up with an adjusted DEPS of $2.83 for 2012. The compounded annual growth rate ["CAGR"] is 19.0% overall and 17.4% on a per share basis. Since this measure may still be underestimating real profitability (as Amazon's non-fixed asset depreciation and amortization has pushed upwards as well), I decided to also take a look at earnings before depreciation and amortization (adjusted for taxes). The results are in the chart below.
This particular metric is extremely favorable to AMZN, showing a profit of $4.30 per share for 2012. The 5-year CAGR for the overall figure is 26.8% and on a per share basis, it's 25.1%. In other words, profits are very high and rapidly growing.
So what's the "true" profitability? It's difficult to estimate given the evolution in Amazon's business over the past few years, but from these figures, I would guess somewhere in the range of $2.83 to $4.30 per share. I view the lower figure as more realistic since the larger figure likely ignores necessary, recurring capital expenditures. That would put my best guess as to "true profitability" somewhere around $3.25 per share.
While $3.25 per share is dramatically better than a 9 cent per share loss, notice that this would still give Amazon a P/E ratio in the range of 90 to 100.
The next question to ask is how rapidly is Amazon growing? The answer is "very."
The chart below shows Amazon's compounded annual growth rates ["CAGR"] for the past 3 and 5 years on six different metrics: revenues, gross profit, cash flows from operations ["CFOs"], CFOs excluding working capital changes, operating income ["OI"] plus fixed asset depreciation ["FA Deprec"], and finally EBITDA.
As you can see, growth is extremely impressive. I favor looking at EBITDA over the other measures, because I believe it's the most consistent measure. The 5-yr CAGR for EBITDA is an outstanding 25.8%!
At the same time, I do wonder how much longer AMZN can grow like this. The chart below compares Amazon's sales revenues, gross profits, gross margins, and market cap with large brick-and-mortar competitors Wal-Mart and Target (TGT).
As you can see, AMZN's sales will probably exceed Target's within 1-2 years. How much longer can it grow revenues 30% YOY, though, before it hits a wall? At some point, it's going to have to start significantly cutting into Wal-Mart's sales to continue growing. That's very bad news for Wal-Mart and one reason I would not want to be a WMT shareholder. Of course, that also suggests that AMZN may be nearing an end of "easy profit growth" within the next five years.
All the same, AMZN is clearly preparing itself for the epic battle versus Wal-Mart. This goes back to the aforementioned warehouse buying spree. AMZN is buying up warehouses to lower deliver times and try to convince more Wal-Mart and Target customers that they are better off buying online. The strategy may very well work, but it will be difficult.
One final takeaway from this chart is Amazon's gross margins are almost identical to Wal-Mart's, but a bit lower than Target's. This somewhat undercuts the idea that AMZN is slashing margins dramatically, and I suspect that this is mostly a mirage coming from GAAP accounting.
While I'm "bullish" on Amazon's business strategy and growth prospects, I'm more skeptical of the stock's valuation. This is mainly because even using my adjusted profit figures, and assuming astronomical growth rates, it's still difficult to come up with a $300+ valuation.
I ran over two dozen DCF scenarios with AMZN. I used my adjusted profit figures, looked at expanding margins, and twiddled around with growth rates. It was exceedingly difficult to come up with the current price.
My best guess scenario put AMZN's true profitability at $3.25 per share, with a 25% - 30% growth rate for the next four years, followed by 20% growth for Years 5 through 6, and then 15% growth in Year 7. After that, I assumed 4% growth for the terminal. I came up with a valuation of $255 in this scenario.
While this is my "best guess", there are several things I don't like about it. For one, 25%+ growth for four years is spectacular. I wouldn't be surprised if AMZN was able to achieve that, but I also wouldn't be shocked if it didn't. 25%+ growth is a very generous assumption, even given AMZN's outstanding historical track record.
In order to get over $300, I had to assume that Amazon's EBITDA margins would improve 140 basis points over the next four years (not totally unrealistic given their history). This scenario also includes approximately 30% growth for the next four years, followed by 20% growth in Years 5-6 and 15% in Year 7, before 4% in the terminal. That gave me a valuation of $315.
As of the time I'm writing this, AMZN sells at $310, but within the past two weeks, sold as high as $320. My primary issue here is that while AMZN is one of the greatest businesses in the US, we have to assume almost astronomical growth for several years, as well as some modest margin improvement, in order to even come with a valuation close to the current stock price. With those huge embedded expectations, it's difficult to envision much upside and there is certainly little "margin of safety" with the stock.
Yet at the same time, there's a reasonable chance (we'll say about 20% - 30%) that AMZN meets the current expectations embedded in the stock price. For that reason, I view shorting the stock as equally dangerous. Of my group of momentum, high-growth stocks that included LNKD, FB, Z, TRLA, and TSLA, I'd view Amazon as the least attractive short of the bunch, and the one that investors are most likely to get burned on.
To put it simply, AMZN has consistently grown for nearly two decades. It has gone from a small internet bookstore to the world's largest retailer in that time. Within 24 months, it will be bigger than Target, one of America's largest brick-and-mortar retailers. This is one of, if not THE best managed company in America. It may be 20% - 30% overvalued, but I wouldn't dare bet against it.
Amazon is no not-for-profit company. Bears are consistently underestimating the firm's true profitability and growth short-sellers are forgetting the maxim to never short based solely on valuation. AMZN is immensely profitable and growing more rapidly than virtually any other large retailer in the world.
Operating margin declines are highly deceiving, and EBITDA margins are probably a better metric to look at. While EBITDA margins have fallen slightly, that also means there's room for improvement in the upcoming years.
AMZN's warehousing strategy is a direct attempt to challenge the world's largest retailer, Wal-Mart, and the two companies could be on a collision course. AMZN will need to eventually start cutting into Wal-Mart's revenues in order to continue its rapid growth. While this may suggest the "easy growth" is over, it should also be scary for Wal-Mart shareholders. Frankly, Wal-Mart is a much more interesting short target than AMZN.
Overall, AMZN is a misunderstood company, and I wouldn't bet against Jeff Bezos. The stock is too expensive for me to recommend a "buy", but the shorts could get burned all the same.
Additional disclosure: I own long-dated puts on FB and NFLX.