Amazon's High Multiple Isn't Sustainable

We all know Amazon (AMZN) reasonably well and have tried its services; it is clearly one of the e-commerce success stories. The recent IIIQ earnings announcement pushed the stock up to $38. But is this stock worth a $16 bn market cap?

Amazon started by selling books online. Great brand, broad catalogue and efficient business model. But after reaching a very high penetration rate in North America and the Rest of the World it is getting harder and harder to find new ways to maintain the high growth rates expected by the market. Amazon Prime is a very good initiative in order to maintain and even grow its market share; however it comes to a price in terms of reduced profitability. And we are talking about a company whose operating margin in 2006 will be in the mid single digit.

Competitors are catching up. When it first entered the market Amazon was offering products at a huge discount to its competitors. And it became a benchmark. It took them a lot to react, but, in order to survive, they had to cut prices and gain efficiency. The gap between Amazon and all the other players is reducing and the trend cannot be but in one direction.

Given the difficulties in its core business, Amazon diversified over time and became a retailer of a larger range of items. Most of these new revenues come from consumer electronics, audio & video, cell phones, etc which are not exactly the easiest products to deal with (they have low margins and become obsolete very soon).

Working capital is a source of cash for Amazon: it receives the money from the client before it has to pay the suppliers. This is a very good situation while the business is growing at 20% p.a. BUT will become an issue (declining cash flows) in the near future when growth rates will gradually slow down.

The company gradually improved its ROIC from 2001 (-20%) to 2004 (+44%); but the environment worsened in 2005 (ROIC of 35%) and in 2006 (32% in the IQ and 23% in the IIQ). Couldn’t this be a sign that the competitive landscape is getting tougher for Amazon?

Think about the different phases in the low cost airlines industry: 1) only traditional airlines and high fares, 2) introduction of a different business model (low cost and low fares), 3) low cost airlines increase market share while traditional airlines are looking for ways to catch up, 4) traditional airlines adopt a segmentation strategy and gain back price sensitive customers. Are we far away from seeing something similar happening to e-commerce?

Now, all these issues could be “business as usual” for a value company. The problem here is that we are talking about a company whose market cap is $16bn and with a consensus GAAP P/E ratio of over 50 for the year 2007.

We do not consider the high multiples at which the company is trading sustainable over the medium- to long-term. Therefore we are shorting the stock. If implied volatility goes up from the current levels (30%) it could be possible to sell out of the money put options in an equal or lower proportion. In this way one can benefit from a decline in the stock price (up to the strike price of the option) while limiting the losses in case the stock goes up a little bit more.

Disclosure: Author is short AMZN

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