Amazon (NASDAQ:AMZN) has been a hot stock recently, pushing new 52 week highs and making headlines over its unveiling of futuristic delivery drones. While it is an exciting company with innovative ideas, there is a strong disconnect between what the company does and how the company is valued. In this article I will explain Amazon should be valued like the volume-retailer that it is rather than the tech company it is valued as.
The Fundamental Disconnect
I do not believe Amazon's business model will allow the business to earn enough money to validate its current valuation any time in the foreseeable future. I have heard several common justifications for the insane valuation placed on Amazon shares, the most common of which being:
1. Amazon will raise prices to increase margins once competition is driven out.
If a company intends to take market share by providing the lowest cost to consumers then it will lose market share when it raises those prices. This is not a business where competition will exit the market to never to be seen again. Already all of Amazon's biggest competitors, which are low-cost, volume retailers, have an online presence and will continue to do so. Wal-Mart (NYSE:WMT) offers perks such as ordering online and picking up in-store in addition to the already existing online storefront. Every major retailer has an online store in addition to physical locations, and the idea that Amazon is better because it lacks physical locations is not supported by any data. This leads me to the next point….
2. Amazon is in a growth stage and is reinvesting everything they make, erasing earnings
This is an issue that has been covered extensively in other articles. What some investors believe to be "investments" are actually variable costs associated with Amazon's business model. Things such as paying for shipping costs and fast delivery are simply not investments. These costs will continue to increase with volume and scaling these operations will not reduce these variable costs significantly enough to expand margins past those of traditional retailers. The costs of trying to be a convenient, low-cost retailer will continue to eat into Amazon's margins indefinitely and should not be a reason for anyone to pay a premium for this stock.
I recognize that Amazon is expanding into other businesses such as cloud storage and video streaming, but these are also low-margin businesses that will face competition from other more specialized players. Netflix (NASDAQ:NFLX) is model for how low margins are in the video streaming business (2.9% profit margin) and I doubt companies like Google (NASDAQ:GOOG) will easily surrender market share in the cloud storage space without first trying to price Amazon out of the market.
Amazon vs Tech Companies
|Gross Margin||24.75%||Gross Margin||37.04%||Gross Margin||61.29%|
|Operating Margin||0.91%||Operating Margin||28.67%||Operating Margin||22.28%|
|Profit Margin||-0.24%||Profit Margin||20.05%||Profit Margin||16.52%|
What I want this chart to make clear is that the tech companies valued near Amazon's sales multiple have much higher margins and turn significantly more of their revenues into profit than Amazon will ever be able to. Giving Amazon the same sales multiple as Apple ensures that Amazon's profits will never justify the price of this stock. I do not claim to know how long a stock can trade at well over 100x earnings but it seems that the market believes AMZN will do so for the foreseeable future. What I do know is that a stock cannot trade at such an insane valuation indefinitely.
Amazon vs Retailers
This chart shows that Amazon's gross margin falls in between that of Costco and Target, almost exactly in line with Wal-Mart's. This makes sense because both Wal-Mart and Amazon are competing as low-cost retailers. To understand how grossly overvalued Amazon is we must again look at the price to sales multiple. AMZN's P/S is nearly 5 times that of Wal-Mart despite both companies having similar margins. Maybe a slightly higher price to sales multiple is warranted by Amazon's greater expected growth, but it is certainly not justified by the idea that Amazon will be able to expand its margins past those of Wal-Mart's. As can be seen, Wal-Mart has significantly better operating and profit margins than Amazon. If Amazon is ever able to match Wal-Mart's margins then I believe they should trade at very similar P/S multiples, with foreseeable future growth being the variable to determine which company's should be higher.
The Noise About Drones
Much ado has been made about Amazon's announcement of delivery drones recently. These drones will have minimal effect on Amazon as an investment for at least 5 years and they will face heavy competition from huge players with deep pockets. I do not think this should be a factor in evaluating Amazon until many important questions about cost, pricing, and competition are available. These questions are unlikely to be answered for at least several years. For that reason, I don't think investors can bank on exciting, futuristic technologies such as drones to give Amazon a competitive edge in the long term future. Rather, I think that services such as this will become a new standard option and margins will be compressed by the presence of meaningful competition.
The conundrum in Amazon's valuation is that it is a business entirely reliant on low prices and convenience, and therefore low margins; but it is valued more like a tech company that produces proprietary goods with high margins. Based on the fact that margins are so low, Amazon should be valued at a much lower price to sales multiple than what it is currently trading at. Remember, Apple, with 37% gross margins, trades at a slightly higher 2.9x sales. Wal-Mart, a company with similar operating margins and business model, trades at 0.54x sales. If the price-to-sales ratio for Amazon remains as high as it is without expanding its margins to impossibly high levels then it seems that Amazon's market price will remain significantly higher than its intrinsic value for the foreseeable future, destroying any upside and creating significant downside potential.