Seeking Alpha
Long only, value, growth at reasonable price
Profile| Send Message|
( followers)  

"At Berkshire we have three buckets: yes, no, and too hard." - Charlie Munger

You can say one thing for Amazon (NASDAQ:AMZN): it's a stock which gives rise to a robust dialogue about price and value. Momentum stocks often seem to me to divide the world between smart folks and idiots with the idiots winning the first few skirmishes but the smart folks winning the war. Amazon isn't quite that simple. There are smart folks on both sides. There are persuasive arguments both ways, but what there doesn't seem to be is a middle ground. Recently it even gave rise to an in-house debate with my son Eugene (for full credit, Gene Sloan the USA Today Cruise Blog creator/writer/editor and no slouch of a value investor). Eugene and I often have email discussions on stocks. We almost always agree, and it comes as bit of a surprise when we don't. From his perspective as 25 years my junior, he provided me with quite an education on Amazon. It started with a casual aside:

Me to Eugene: I love the back and forth at SA on Amazon. I'm not totally sure, but I kind of think that it is going to be one of the all time shorts once it starts to break down. I'll look at the puts, but probably pass. Hell, they are great at everything, but they don't make any money. What the hell is that? They totally kill the whole retail industry and run at a loss. I don't get it. I wasn't great at getting Google either, however. Or Apple. Or Facebook, which I think is of, by and for idiots. Like Munger and Buffett I have a "too hard" file.

I was sort of shocked when Eugene came back with the other side of the argument:

Eugene to Me: I think what Amazon is doing is just quietly taking over huge chunks of retailing, and they don't care about profits now because they know that the bigger they get the less anyone could ever catch up. As long as they don't lose money and bring in enough cash flow to keep the business growth there's no need for profits now. Better to keep getting bigger. So I think they set their prices at a point where they can just break even and keep undercutting everyone else by oodles. I find myself buying more and more from them, which makes me realize they are the new Wal-Mart. They are getting to the size where, like Wal-Mart a couple decades ago, nobody can compete. Nobody ever will be able to build the network of distribution centers that they are now building, so that you can order something this morning and it arrives this afternoon. Amazing. And in addition to what they sell for themselves, they're becoming the marketplace for everyone else from mom-and-pop businesses to large retailers to list their goods, with Amazon getting a cut. I even sell on Amazon myself! (used books and other used things; they take 15%). I just bought this big battery pack thing that Morgan needed for her photography. Made by Duracell, it can run a huge set of lights in the field. It cost $229 retail from Duracell.com and a bunch of other outlets, and I found it on about a dozen discount sites and places like homedepot.com for $179. Amazon had it for $149 - fully $30 cheaper than the lowest price anywhere else. They're not just undercutting others by a few percentage points but like 20%. They are being ruthless. Basically now anything but food and stylish clothing that I need I just go to Amazon. In five years when everyone is trained to go there first and places like Best Buy are liquidated, they can raise their prices by 5%, still undercutting everyone else by 15%, and have huge profits. What's 5% of hundreds of billions? The Internet has so much price transparency that whoever can offer stuff for the lowest price is going to win.

Anyways, that's my take on them. That said, I don't own the stock as I can't figure out what a right amount to pay for that sort of domination is. How did Wal-Mart trade in its explosive years? Was it at 200 times earnings ever?

On the one hand Eugene had made the pro-Amazon argument come alive to me. On the other hand he had admitted that Amazon was in his "too hard" bucket as well. He had also raised the Wal-Mart (NYSE:WMT) question, which began to fester in my brain. So I tried to move beyond thesis and antithesis, toward an attempt at synthesis:

Me to Eugene: You make a very good argument. I have seen several like it on SA, but you really put it better than the rest, using your personal example effectively. I am almost convinced. I certainly will never short Amazon unless the market goes into clear beginnings of a major tailspin with the high flyers the obvious sources of cash. But I also won't buy it even though a few managers I think very well of own it, some of them value managers.

My overall view of Amazon is that its future is similar to the division of current opinion on it: binary. It could go either way, and I don't think resolution of two good arguments can really be done very well. One side will be proved pretty much right and the other side pretty much wrong, but I think from the present moment that outcome is more random and coin-flippish than determinable by best information and best rational analysis. My one addendum to the bear side is that Wal-Mart always made money. It was therefore always priced on the basis of an earnings stream which grew rapidly but with some consistency. It was quite expensive at times, especially around 2000, but around 30 to at most 50 times (I'm not sure it ever hit the latter). A PE of 30 for a company growing as fast as Wal-Mart was is fine, earnings growth will overpower it. WMT has followed the basic life cycle of a company, needing borrowed money at first, growing very fast (and priced expensively), then settling into a glide path as growth slows (and ultimately falters) with a downward PE repricing into being a value stock. One of the current problems with Amazon is that it doesn't give an indication where the earnings growth series starts. If it is current earnings, this is a very pricey stock indeed. Another problem is that they intend to allow themselves to earn money only after sweeping the board, in other words becoming WMT circa 1995. There can be good growth after that, but it will quickly settle into the growth level of the consumer economy, not a good growth story. I don't want to own Amazon with slow growth glide path or hitting a plateau. Finally, retail is a low margin business, just its nature (except for luxury items, which isn't what people buy on Amazon or at WMT). It is always under attack from every direction - newcomers, customers, suppliers, etc. I have never owned a retail stock (which is what Amazon is) because I don't personally buy stuff, for the most part, and I sort of don't get buying stuff and certainly can't figure what, why, and how others do.

That was the Amazon exchange, but it didn't quite get around the real Amazon question. The tech stocks Buffett won't buy (except IBM, of course) are "too hard" because their technologies are hard to grasp in business terms unless you are a nerd versed in the area and the durability of their moat is hard to assess. Amazon isn't like that. It's dead stone simple. So why do my son and I both have it in the "too hard" bucket?

Forget earnings and cash flows. Forget the debate of how to look at costs of the build out of distribution. Let's, for the sake of discussion, buy the best case argument. It's all going to happen for Amazon. They will sweep the board. They will print money by a relatively small increase in prices. We don't care one bit what happens this year or the next or the next. We'll take it on its own terms.

Amazon Versus Wal-Mart

What we should care about with Amazon is the question of overall life cycle which applies to most corporations. All companies pass through it, a passage closely analogous to the life of human beings, but retail companies are particularly textbook in their life cycles. The lesser ones start small and regional with a new angle on something, run away with the local market, start building out a national chain of stores with the necessary logistics, then sometimes go international. After a few years they find they have reached market saturation, margins level off and start to sink, and they find other new arrivals nipping at their heels. A few large retail enterprises, however, have an innovation so primary that their life cycle is much longer. For Sears, with its catalog, layaway plan, and emphasis on quality, that life cycle was about a century before others, and especially Wal-Mart, started nipping at its heels. One thing to remember here is that the pace of innovation and obsolescence has picked up a good deal, and the new challengers sometimes don't even appear on the radar until it is too late.

Now let's think about Wal-Mart. I got so interested in Eugene's comparison that I looked up Wal-Mart annual reports all the way back to 1970. I got a small surprise: at the beginning Wal-Mart wasn't even an expensive stock. It sold as low as twelve times earnings or so in the 1970s, in an era of generally low PEs, I should add to be fair. In the 1980s it really took off. Its PE grew as its earnings growth persisted and it ran over the competition, but it wasn't really very expensive until it zoomed up next to the dot coms around 2000. After all, by then it was as much of a growth superstud as they were supposed to be. And I was right in what I told my son: it always had earnings and a small dividend. The earnings, cash flow, and margins were enough to be the basis for real measurement. In the early 90s it shot past Sears and retailers of the old model, and everything ate Wal-Mart's dust. So where did Wal-Mart ultimately arrive?

Wal-Mart is now a slow-to-moderate growth company with a decent dividend. EPS growth is around 9% or so annually, and probably destined to gradually decline. The PE is 13 or 14. The dividend is just under 2.5%. But let's compare it to Amazon with metrics which might apply. Wal-Mart's market cap is around 250 billion. Amazon's is around 164 billion. In other words, Amazon has a market cap about 65% that of Wal-Mart, with basically no earnings or dividend. Wal-Mart has sales of 473 billion; Amazon has sales of 70 billion. In other words Wal-Mart sells for a little over 50% of sales; Amazon sells for 2.3 times sales. In terms of price, Amazon is where Wal-Mart was two years ago. In terms of sales, it is where Wal-Mart was a couple of decades ago. Amazon may get to a half trillion of sales quicker than Wal-Mart did, heck, it may get to a trillion of sales, but to picture a future when it has grown into its present clothes you have to look at the imaginary picture through an imaginary telescope.

The question is not whether you would prefer Amazon or Wal-Mart. The important point is that Amazon IS Wal-Mart, but at an earlier point on the growth curve. But remember the truth about growth curves. They are like bacteria in a petri dish. They usually have an S shape. The first derivative of growth diminishes, although how soon and how much isn't always clear during the steep part of the ascent. For fun, though, look at the earnings growth of Google (NASDAQ:GOOG), which was tripling every year a decade ago and has settled down to 12% or so the last couple of years in a series that fits nicely to a standard growth curve. It happened to Wal-Mart. It happens to everything. It will eventually happen to Amazon.

Let's say that Amazon gets to be Wal-Mart, with half a trillion of sales. Let's say it massacres its competitors, including Wal-Mart (which, by the way, might put up a smarter fight than Sears did). Let's assume that Amazon achieves profit margins at will, as Eugene suggests, exceeding those of Wal-Mart or previous dominant retail firms. It will still tend to have growth slowing to the growth of the economies it serves. That will fetch maybe 15 times earnings as it is recognized as a mature retail company. And it will happen some years down the road, a little hard to estimate, but years in which investment dollars would have been providing returns of some sort in other investments. Money has term value, after all, and Amazon isn't offsetting it to any significant extent at the present. So the Amazon bulls may be completely correct. Or one or another of the necessary factors may miss badly, including the time estimates for Amazon to start cranking out distributable profits. So the bears may be correct too, for all practical purposes. The outcome is basically beyond reasonable calculation. It is binary. It's just too hard.

And by the way, Eugene: Wal-Mart never traded at anything close to 200 times earnings.

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.

Source: Why Amazon Belongs In The 'Too Hard' Bucket